Unemployment and Inflation

 three models of aggregate supply in which

output depends positively on the price
level in the short run
 the short-run tradeoff between inflation
and unemployment known as the Phillips
curve

CHAPTER 13 Aggregate Supply slide 1

A new and improved short run AS curve

P
Y  Y : LRAS
Y  Y   (P  P )
new SRAS

P  P : old SRAS

Consider a more realistic case, in between the two

extreme assumptions we considered before.
CHAPTER 13 Aggregate Supply slide 2
Three models of aggregate supply
Consider 3 stories that could give us this SRAS:
1. The sticky-wage model
2. The imperfect-information model
3. The sticky-price model
e
Y  Y   (P  P )
agg. the expected
output price level
a positive
natural rate parameter the actual
of output price level
CHAPTER 13 Aggregate Supply slide 3
 The sticky-wage model
 Assumes that firms and workers negotiate
contracts and fix the nominal wage before they
know what the price level will turn out to be.
 The nominal wage, W, they set is the product
of a target real wage, , and the expected price
level:
W  ω P e
W Pe
 ω
P P

CHAPTER 13 Aggregate Supply slide 4

 The sticky-wage model
W Pe
ω
P P

If it turns out that then

e unemployment and output are
P P at their natural rates
Real wage is less than its target,
P Pe so firms hire more workers and
output rises above its natural rate
e Real wage exceeds its target, so
P P firms hire fewer workers and
output falls below its natural rate

CHAPTER 13 Aggregate Supply slide 5

 (a) Labor Demand (b) Production Function
Real wage, Income, output, Y
W/P
W/P 1 Y 5 F(L)
Y2
W/P 2
Y1
L 5 Ld(W/P )

4. . .. output,. .
2. .. . reduces L1 L2 Labor, L L1 L2 Labor, L
the real wage 3. . ..which raises
for a given
employment,. .
nominal wage, ..
(c) Aggregate Supply
Price level,P Y 5 Y 1 a (P 2 Pe )

P2
6. The aggregate
P1 supply curve
summarizes
these changes.
1. An increase
in the price Y1 Y2 Income, output, Y
level. .
CHAPTER 13 Aggregate Supply 5. . .. and income. slide 6
 The sticky-wage model
 Implies that the real wage should be counter-
cyclical , it should move in the opposite
direction as output over the course of business
cycles:
– In booms, when P typically rises, the real
wage should fall.
– In recessions, when P typically falls, the real
wage should rise.
 This prediction does not come true in the real
world:

CHAPTER 13 Aggregate Supply slide 7

 The cyclical behavior of the real wage
Percentage
change in real 4 1972
wage
3
1998
1965
2
1960 1997
1999
1
1996 2000
1970 1984
0
1982 1993
1991 1992
-1
1990
-2 1975

-3 1979
1974

-4
1980
-5
-3 -2 -1 0 1 2 3 4 5 6 7 8
Percentage change in real GDP

CHAPTER 13 Aggregate Supply slide 8

The imperfect-information model
Assumptions:
 all wages and prices perfectly flexible,
all markets clear
 each supplier produces one good,
consumes many goods
 each supplier knows the nominal price of
the good she produces, but does not know
the overall price level

CHAPTER 13 Aggregate Supply slide 9

The imperfect-information model
 Supply of each good depends on its relative
price: the nominal price of the good divided by
the overall price level.
 Supplier doesn’t know price level at the time
she makes her production decision, so uses the
expected price level, P e.
 Suppose P rises but P e does not.
Then supplier thinks her relative price has risen,
so she produces more.
With many producers thinking this way,
Y will rise whenever P rises above P e.
CHAPTER 13 Aggregate Supply slide 10
 The sticky-price model
 Reasons for sticky prices:
– long-term contracts between firms and
customers
– menu costs
– firms do not wish to annoy customers with
frequent price changes
 Assumption:
– Firms set their own prices
(e.g. as in monopolistic competition)

CHAPTER 13 Aggregate Supply slide 11

 The sticky-price model
 An individual firm’s desired price is
p  P  a (Y Y )
where a > 0.
Suppose two types of firms:
• firms with flexible prices, set prices as above
• firms with sticky prices, must set their price
before they know how P and Y will turn out:
p  P e  a (Y e Y e )

CHAPTER 13 Aggregate Supply slide 12

 The sticky-price model
p  P e  a (Y e Y e )
 Assume firms w/ sticky prices expect that
output will equal its natural rate. Then,
p Pe
 To derive the aggregate supply curve, we first
find an expression for the overall price level.
 Let s denote the fraction of firms with sticky
prices. Then, we can write the overall price
level as

CHAPTER 13 Aggregate Supply slide 13

 The sticky-price model
e
P sP  (1  s )[P  a(Y Y )]

price set by sticky price set by flexible

price firms price firms

 Subtract (1s )P from both sides:

sP  s P e  (1  s )[a(Y Y )]
 Divide both sides by s :
e  (1  s ) a 
P  P   (Y Y )
 s 
CHAPTER 13 Aggregate Supply slide 14
 The sticky-price model
e  (1  s ) a 
P  P   ( Y Y )
 s 
 High P e  High P
If firms expect high prices, then firms who must set
prices in advance will set them high.
Other firms respond by setting high prices.
 High Y  High P
When income is high, the demand for goods is high.
Firms with flexible prices set high prices.
The greater the fraction of flexible price firms,
the smaller is s and the bigger is the effect
of Y on P.
CHAPTER 13 Aggregate Supply slide 15
 The sticky-price model
e  (1  s ) a 
P  P   ( Y Y )
 s 

 Finally, derive AS equation by solving for Y :

Y  Y   (P  P e ),
s
where  
(1  s )a

CHAPTER 13 Aggregate Supply slide 16

 The sticky-price model
In contrast to the sticky-wage model, the sticky-
price model implies a procyclical real wage:
Suppose aggregate output/income falls. Then,
 Firms see a fall in demand for their products.

 Firms with sticky prices reduce production,

and hence reduce their demand for labor.
 The leftward shift in labor demand causes
the real wage to fall.

CHAPTER 13 Aggregate Supply slide 17

 Summary & implications

P LRAS
Y  Y   (P  P e )

P Pe
SRAS
Each of the
P Pe
three models of
P Pe agg. supply imply
the relationship
Y summarized by
Y the SRAS curve
& equation

CHAPTER 13 Aggregate Supply slide 18

 Summary & implications
SRAS equation: Y  Y   (P  P e )
Suppose a positive
AD shock moves
P SRAS2
output above its LRAS
natural rate SRAS1
and P above the
level people
P3  P3e
had expected.
P2
Over time, AD2
P2e  P1  P1e
P e rises,
AD1
SRAS shifts up,
and output returns
Y
to its natural rate. Y2
Y 3  Y1  Y
CHAPTER 13 Aggregate Supply slide 19
 Inflation, Unemployment,
and the Phillips Curve
The Phillips curve states that  depends on
 expected inflation, e
 cyclical unemployment: the deviation of
the actual rate of unemployment from the
natural rate
 supply shocks, 

where  > 0 is an exogenous constant.

CHAPTER 13 Aggregate Supply slide 20

 Deriving the Phillips Curve from SRAS
(1) Y  Y   (P  P e )

(2) P  P e  (1  ) (Y Y )

(3) P  P e  (1  ) (Y Y )  

(4) (P  P1 )  ( P e  P1 )  (1  ) (Y Y )  

(5)    e  (1  ) (Y Y )  

(6) (1  ) (Y Y )    (u  u n )

(7)    e   (u  u n )  
CHAPTER 13 Aggregate Supply slide 21
 The Phillips Curve and SRAS
SRAS: Y  Y   (P  P e )
Phillips curve:    e   (u  u n )  
 SRAS curve:
output is related to unexpected movements
in the price level
 Phillips curve:
unemployment is related to unexpected
movements in the inflation rate

CHAPTER 13 Aggregate Supply slide 22

 Adaptive expectations
 Adaptive expectations: an approach that
assumes people form their expectations of
future inflation based on recently observed
inflation.
 A simple example:
Expected inflation = last year’s actual inflation
 e   1

 Then, the P.C. becomes

   1   (u  u n )  

CHAPTER 13 Aggregate Supply slide 23

 Inflation inertia
n
   1   (u  u )  
 In this form, the Phillips curve implies that
inflation has inertia:
– In the absence of supply shocks or cyclical
unemployment, inflation will continue
indefinitely at its current rate.
– Past inflation influences expectations of
current inflation, which in turn influences
the wages & prices that people set.

CHAPTER 13 Aggregate Supply slide 24

Two causes of rising & falling inflation
   1   (u  u n )  
 cost-push inflation: inflation resulting
from supply shocks.
Adverse supply shocks typically raise
production costs and induce firms to raise
prices, “pushing” inflation up.
 demand-pull inflation: inflation resulting
from demand shocks.
Positive shocks to aggregate demand cause
unemployment to fall below its natural rate,
which “pulls” the inflation rate up.
CHAPTER 13 Aggregate Supply slide 25
 Graphing the Phillips curve

In the short 
run, policymakers
face a trade-off

between  and u. 1 The short-run
e  Phillips Curve

u
un

CHAPTER 13 Aggregate Supply slide 26

 Shifting the Phillips curve
People adjust
their 
expectations
over time, so
the tradeoff  2e  
only holds in  1e  
the short run.

E.g., an increase
u
in  shifts the
e un
short-run P.C.
upward.
CHAPTER 13 Aggregate Supply slide 27
 The sacrifice ratio
 To reduce inflation, policymakers can
contract agg. demand, causing
unemployment to rise above the natural rate.
 The sacrifice ratio measures
the percentage of a year’s real GDP
that must be foregone to reduce inflation
by 1 percentage point.
 Estimates vary, but a typical one is 5.

CHAPTER 13 Aggregate Supply slide 28

 The sacrifice ratio
 Suppose policymakers wish to reduce inflation
from 6 to 2 percent.
If the sacrifice ratio is 5, then reducing inflation
by 4 points requires a loss of 45 = 20 percent
of one year’s GDP.
 This could be achieved several ways, e.g.
– reduce GDP by 20% for one year
– reduce GDP by 10% for each of two years
– reduce GDP by 5% for each of four years
 The cost of disinflation is lost GDP. One could
use Okun’s law to translate this cost into
unemployment.
CHAPTER 13 Aggregate Supply slide 29
 Rational expectations
Ways of modeling the formation of
expectations:
 adaptive expectations:
People base their expectations of future
inflation on recently observed inflation.
 rational expectations:
People base their expectations on all
available information, including information
about current and prospective future
policies.

CHAPTER 13 Aggregate Supply slide 30

 Painless disinflation?
 Proponents of rational expectations believe
that the sacrifice ratio may be very small:
 Suppose u = u n and  = e = 6%,
and suppose the Fed announces that it will
do whatever is necessary to reduce inflation
from 6 to 2 percent as soon as possible.
 If the announcement is credible,
then e will fall, perhaps by the full 4 points.
 Then,  can fall without an increase in u.

CHAPTER 13 Aggregate Supply slide 31

 The sacrifice ratio
for the Volcker disinflation
 1981:  = 9.7%
Total disinflation = 6.7%
1985:  = 3.0%

year u un uu n
1982 9.5% 6.0% 3.5%
1983 9.5 6.0 3.5
1984 7.4 6.0 1.4
1985 7.1 6.0 1.1
Total 9.5%

CHAPTER 13 Aggregate Supply slide 32

 The sacrifice ratio
for the Volcker disinflation
 Previous slide:
– inflation fell by 6.7%
– total of 9.5% of cyclical unemployment
 Okun’s law:
each 1 percentage point of unemployment
implies lost output of 2 percentage points.
So, the 9.5% cyclical unemployment
translates to 19.0% of a year’s real GDP.
 Sacrifice ratio = (lost GDP)/(total disinflation)
= 19/6.7 = 2.8 percentage points of GDP
were lost for each 1 percentage point
reduction in inflation.
CHAPTER 13 Aggregate Supply slide 33
 The natural rate hypothesis
Our analysis of the costs of disinflation, and of
economic fluctuations in the preceding chapters,
is based on the natural rate hypothesis:
Changes
Changesininaggregate
aggregatedemand
demand
affect
affectoutput
outputand andemployment
employment
only
onlyininthe
theshort
shortrun.
run.
In
Inthe
thelong
longrun,
run,
the
theeconomy
economyreturns
returnstoto
the
thelevels
levelsofofoutput,
output,employment,
employment,
and
andunemployment
unemploymentdescribed
describedbyby
the
theclassical
classicalmodel
model(chapters
(chapters3-8).
3-8).
CHAPTER 13 Aggregate Supply slide 34
 Chapter summary
1. Three models of aggregate supply in the short
run:
 sticky-wage model
 imperfect-information model
 sticky-price model
All three models imply that output rises above
its natural rate when the price level rises above
the expected price level.

CHAPTER 13 Aggregate Supply slide 35

 Chapter summary
2. Phillips curve
 derived from the SRAS curve
 states that inflation depends on
 expected inflation
 cyclical unemployment
 supply shocks
 presents policymakers with a short-run
tradeoff between inflation and
unemployment

CHAPTER 13 Aggregate Supply slide 36